Inconsistencies scupper OBR projections

Autumn statement may not prevent short-term slowdown

by Brian Reading in London

Fri 2 Dec 2016

Philip Hammond, the British chancellor of the exchequer, revealed in his 23 November autumn statement plans to shrink the budget deficit at a slower rate than his predecessor George Osborne had set out last March. Osborne failed to meet his targets, but Hammond is more realistic. Shrinking the deficit puts downward pressure on GDP growth. Austerity continues to represent government fiscal policy, but has been scaled back.

The target is the structural budget deficit. The estimated cyclical deficit, caused by the economy running below potential, is subtracted from the overall deficit. Tax and spending changes reduce the structural deficit, but it is a two-way street. Tighter fiscal policy slows growth and increases the cyclical deficit, meaning the overall deficit falls by less than the structural deficit.

Gauging the cyclical deficit and the level of spare capacity is largely guesswork. Projecting how the deficits will change in the future is prone to even greater error. The independent Office for Budget Responsibility makes these guesses, meticulously and transparently examining all the evidence, and yet still frequently gets it wrong.

The fiscal multiplier, which is the ratio of change in national income to the change in government spending that causes it, measures the impact of structural budget changes on the economy and hence on the cyclical deficit. When Alistair Darling, Labour chancellor of the exchequer under Prime Minister Gordon Brown, inaugurated austerity in 2010 the multiplier was assumed to be small. Fiscal stringency was expected to create room for looser monetary policy. It did, but the decline in the overall deficit was disappointing, largely due to the GDP impact from the euro area recession. Hammond’s lesser tightening will have a larger multiplier impact because monetary tightening is anticipated. Fiscal policy will remain restrictive and monetary policy may become so. These forces will be exacerbated by Brexit uncertainty, weaker private investment, and the impact on consumer incomes from sterling depreciation and higher prices.

Today’s orthodoxy rests on Keynesian real demand analysis. An improved balance of trade in goods and services will not add sufficiently to demand to offset negative factors. Trade excludes investment income from the current account balance, which will improve by more than the trade balance. The UK’s current account deficit is others’ financial surplus. It is matched by the sum of domestic sectors’ financial deficits. The chancellor intends to reduce the public sector deficit, but without a fall in the foreigners’ surplus the financial deficit of the domestic private sector, which includes businesses plus households, will rise.

The OBR’s sector balance projections are revealing. The foreign surplus declines, while the public sector balance benefits most. The business sector’s balance also improves. The driving force is the deterioration in the household sector’s financial balance to a larger deficit than before the financial crisis. The underlying deterioration is worse.

Increased pension fund deficits are included in household savings, but these never reach consumers’ pockets. When they are excluded, the household savings rate becomes seriously negative, and the gross debt ratios of households approach pre-crisis levels. Continued asset price inflation keeps net debt manageable but wealth inequality makes aggregates misleading. The rich benefit but don’t borrow. This is inconsistent when monetary policy tightens.

Equally inconsistent is the projection of many more years of stagnant real wage incomes coupled with continued, if slower, real GDP growth. When spare capacity is judged to be near exhausted, a continued decline in the share of labour to capital is implausible. Investment is derived demand from consumer spending. A rising share of labour income helps to correct financial imbalances. It supports investment and increased productivity through capital deepening. The new policy mix inspired by Brexit may not prevent a short-term slowdown, but it could transform medium-term prospects. So far, fears of a recession after the Brexit vote have proved unfounded. It is early days yet.

Brian Reading was an Economic Adviser to Prime Minister Edward Heath and is a Member of the OMFIF Advisory Board.